The effect of the 1981 US tax reform on the US and world economies has been a contentious issue. Between 1979 and 1984 the inflation-adjusted deficit of the public sector increased by $162 billion, the US current account deteriorated from a small surplus in 1981 to a deficit of almost $100 billion in 1984, and real interest rates rose to unprecedentedly high levels. These high real interest rates, it is argued, stem primarily from the need to finance the massive US budget deficit and have damaged the performance of the world economy. The US administration has put forward a very different view: tax cuts have increased the incentive to work and save and have raised the rate of growth of US output. The current account deficit is merely the counterpart of the capital which has flowed into the United States as a result of the renewed dynamism of its economy.

Theoretical analyses of the impact of fiscal policy have proved equally controversial: some have assumed a 'classical world', inhabited by infinitely long-lived optimizing consumers. In such models a bond-financed tax cut has no effect on real interest rates: consumers increase their savings in anticipation of the future tax liabilities implied by the issue of bonds; this increase in private savings matches the increase in the government deficit. Other analyses suggest that consumers have no reason to take into account these future tax liabilities. Private savings do not automatically rise to finance the increased deficit; world interest rates must rise, and this 'crowds out' investment at home and abroad and leads to a fall in net external assets. Most of these analyses, however, do not consider the effects of the tax system on individual incentives to work and save or on firms' decisions to invest. Yet the view that taxation distorts these choices is at the heart of the new conservative economic strategy.

In Discussion Paper No. 153, Research Fellows Charles Bean and Sweder van Wijnbergen analyse the medium- and long-run effects on the domestic and world economy of a programme of cuts in taxes on capital or labour income. In order to capture the important intertemporal aspects of the private sector's response to tax cuts they use a two-country version of the standard overlapping- generations growth model, which they extend to capture not only the direct effects of an increased budget deficit but also the effects of tax cuts on the incentives to save and to work, on investment and on other economies. Bean and van Wijnbergen analyse the effects of a tax cut which is financed initially by debt sales; in later periods the government adjusts its spending to maintain the new levels of debt per capita. The authors highlight a number of channels through which such tax cuts affect the economy.

Investment, for example, will be affected by cuts in labour and capital taxes. A reduction in capital taxes will increase the after-tax rate of return on capital and will lead to higher investment. This effect is well known: Blanchard and Summers have argued that the high levels of real interest rates in the United States have been due not to the US budget deficit but to high levels of investment demand arising from changes in capital taxation. Bean and van Wijnbergen identify another possible explanation: an announcement that labour taxes will be cut in the future will affect investment, through changes in future factor prices. Such an announcement will, they argue, increase the incentive to work and lead individuals to plan an increase in their labour supply in the future. This tends to increase output in the future, requiring a larger capital stock.